Wednesday, 26 October 2011

The Mystery of the Triple A rating and the Reincarnation of the CDO

Speaking last month, Christine Lagarde stated that if banks could raise sufficient funds on the open markets to meet their liabilities and Basel III requirements within the certified time (between 7 and 9% of capital to risk-weighted assets) then governments should step in and lend to the banks. No-one, it would seem, wants this outcome. The banks retaliated with claims that they were not in need of a second "bail out", and there aren't many taxpayers who would be happy with another round of bank bailouts.

But it's not just banks. At the end of last year, Ireland needed a bailout. Greece and Portugal swiftly followed, and now Italy and Spain have joined the list of those 'giving cause for concern'. The European Financial Stability Facility was set up following the Irish bailout as a means of dealing with the problem. At the time, no-one expected, and likely intended, for the fund to be used. It was intended merely as a 'back up' plan that would encourage the market to lend to Ireland. But this never happened, and now - unable to fulfil the government guarantees of banks - Ireland cannot raise money on the markets. Estimated interest rates of 7% on Irish government bonds being unsustainable, Ireland had to look elsewhere, and the EFSF was the remaining option.

The EFSF, it is anticipated, will borrow €750 trillion from the markets and will lend to countries in need.The means of the EFSF are combined with loans of up to € 60 billion coming from the European Financial Stabilisation Mechanism (EFSM), i.e. funds raised by the European Commission and guaranteed by the EU budget, and up to € 250 billion from the International Monetary Fund. In other words, the fund is a special purpose vehicle (SPV) set up to lend money to countries that can't issue bonds on the markets. Investors who won't lend to Ireland and Spain because of their poor economic situations are being asked to lend to the EFSF, which will in turn lend ot Ireland and Spain. The core countries of the Eurozone have agreed to guarantee the fund, though, so each are liable for the defaults of others. Germany, France and Italy are the largest contributors, making Germany, France and Italy liable in large part for the debts of countries who borrow from that fund. So far so good.

All of the big three ratings agencies were asked to assign the fund a triple A rating - the highest possible, and each agreed. This was justified on the basis that those countries guaranteeing the loans could afford to honour their guarantees. But the fund is essentially supplying loans to people who can't borrow anywhere else because it is unlikely they'll be able to pay the loan back. It's also guaranteed by countries who aren't solvent either (Ireland, Greece, Portugal, Spain and Italy are all guarantors too). Put this way, the triple A rating assigned seems surprisingly optimistic - reminiscent almost of the CDOs that came to symbolise the worst of the sub-prime mortgage crisis.

Of course, the CRAs have defended their actions, citing Germany's surplus and the structure of guarantees involved. Indeed, Scott Mather, Pimco fund manager, has stated that if the EFSF just loans to Ireland then the fund appears to be a fairly safe bet. The problem comes if and when more countries need to borrow from the fund. By guaranteeing Ireland's loan from the EFSF, Spain, for example, will have to set aside assets to cover the guarantee, leaving less room for manoeuvre should anything go wrong, and making it more likely to need to borrow from the fund itself. The more countries that borrow, the fewer guarantors there are, and the rating assigned will drop. In the worst case scenario, Germany, and to a lesser extent France, will be left lending to the rest of Europe, and most likely writing off a significant part of any loan. This - as we are all well aware - is well after the point at which politics steps in and marks the end of the single currency experiment - and is the worse case scenario.

It is worth noting a couple of final points. The AAA rating for the fund was necessary because the investment it is seeking to attract is mainly funds. Pension funds and other investors who usually look for low(er) risk vehicles that are investing the life savings of teachers, postal workers, etc. Ireland had its first bail out nearly one year ago. It followed IMF advice and introduced strict austerity measures. The economy has shrunk by 20%, unemployment is in the high teens and debt to GDP ratio has soared to over 100%. IMF advice hasn't solved anyone's problems, yet it is still being offered as the solution, in the form of a second bailout package. Greece is in the same situation. It is estimated that Greek debt will rise form €270 billion to €340 billion in four years time. This is predicated on the assumption that Greece follows IMF advice by introducing strict austerity measures. The problem is that Greece can't afford to service its current debt levels, let alone increased levels. Massive write offs are the only way that Greece is going to be able to default 'gently', although it does bring the wisdom and the function of the EFSF into question even further.

For more on this see NPR's Planet Money podcast on the issue. An FAQ factsheet on the EFSF is available here.

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